As reported in the cover story this week, Barron's outlines the argument that we may be seeing a near-term top in the crude oil markets, and in fact, this may be a sign of a bursting bubble. To setup the argument, Barron's discusses the impact of supply and demand, along with the effects of institutional investments in commodity-linked indexes. For a quick overview, Barron's provides a nice one page overview of oil supply and demand, along with a chart showing the linkage of the price of crude oil as compared to the rise of the Nasdaq Composite in the late 1990s. While Barron's does present the various points for crude oil prices increasing and decreasing (discussed more below), it refers in both the article and video linked below to the "eerily similar" linkage between crude oil prices and the Nasdaq Composite, and how this implies a correction is possible. While a correction is possible, and may be setting-up as we speak, I am not sure it will be happening simply because the price pattern looks like a previous non-commodity bubble, technical analysis notwithstanding. Even Barron's straddles the fence somewhat by stating that prices could increase to $200 a barrel in the next decade, but could fall to $100 a barrel by year end - not exactly your typical deflating bubble, but more like a short-term pull back or correction.
So what exactly are the pro and con arguments regarding the bubble bursting? As to demand, it is mentioned how while the U.S. per-capita oil consumption is 25 barrels annually, both China and India are small in comparison, with China consuming only two barrels per person per year, with India consuming less than one barrel per person per year. Given that China and India have 1.3 and 1.1 billion citizens, respectively, there is an expectation that oil demand will increase in each of these countries as more of their citizens look to enjoy the fruits of the world, such as air conditioning, automobiles, refrigeration, and computers.
It is further speculated that China has been hoarding diesel fuel ahead of the Olympics in order to produce electricity without coal generation - which has been polluting the country, in particular Beijing where the Olympics are being held. China will likely go back to the cheaper coal once the games are over, thereby reducing diesel demand. China has also recently raised prices on gasoline by 18% (see previous post), a move that is expected to place further pressure on demand, although as described in the post, some feel this may just allow pent-up demand to be satisfied as profitability will return for refiners who have been hurt by higher crude oil costs, but have not been able to pass prices on to customers. This has essentially reduced the gasoline supply in China as refiners shut down or scale back operations. Better margins will now increase supply for consumers demanding gasoline, even at higher prices.
It is also mentioned in the article how Saudi Arabia has pledged to boost production by 200,000 barrels a day, from 9.5 million barrels a day to 9.7 million barrels a day, in order to take pressure off prices (see previous post). The potential for supply-oriented news out of this weekend's summit for oil producers and consumers may also generate additional production increase promises. Unfortunately, much of this oil is sour, and not the light sweet crude currently demanded by the markets, and also subsequently responsible for driving up prices. Whether the Saudi's even have the ability to increase production in their aging fields is also a concern regarding any promised production increases.
As for global oil consumption, it is down in total for the OECD nations (which account for more than half of all global oil demand). Demand itself is currently running about 86 million barrels a day and is expected to be relatively flat as nations cut back on consumption, in particular, automobile miles traveled. Yet, oil demand continues to grow in the developing world, and it will be difficult for even developed countries to reverse their trends quickly. As stated by Byron Wien, the chief investment strategist at Pequot Capital Management, "The world isn't finding oil fast enough to replace the 3% to 4% that gets pumped every year." With oil being controlled by governments that have an interest in maximizing revenues, it is unlikely they will have any near-term interest in boosting current production until the signs of demand destruction become more evident. With supply projections even less, at around 85 million barrels a day, with excess demand currently being made up from inventories, lower demand may result in break-even levels at best.
Some analysts are also speculating (hoping) that the U.S. Federal Reserve will begin raising interest rates later this year, which while helping to fight inflation in general, would also help boost the dollar, thereby reducing the cost of dollar dominated crude oil. Given the upcoming presidential election, and the history/attempts of the Fed to stay neutral during the second half of election years, it is unlikely they will do anything until the elections are over in November. The same could also be said for opening up the Strategic Petroleum Reserve. It is unlikely that the president will begin flooding the market this year in an attempt to increase supply and lower prices, although the government recently did stop purchasing oil for the reserve. If the president would begin selling, it would no doubt appear political, even if welcomed. Ironically, opening up the SPR might end up being a good trade if the country was able to sell oil at current prices when it was bought on average at much cheaper prices. Of course, what prices would be paid in the future to replace the oil is unknown. In addition to the SPR, the lifting of off-shore and protected land oil drilling bans could also have some impact. While it is often argued that the impact would be longer-term, as much as 10 years out, lifting of the bans would certainly send a signal that the U.S. is finally getting serious about the problem and is willing to consider all alternatives, not to mention putting political partisanship behind it. Of course, I would not hold my breath on that one, but if prices continue to rise, expect to see pubic support for lifting the bans begin to shift as the U.S. approaches the next election.
Of course, no article on crude oil prices is worth it salt without discussing speculation and investment. While speculation is not discussed in great detail in the article, the increase in commodity index investing is. Investments by endowments, pension funds, and institutional investors has totaled $260 billion as of March, up from just $13 billion in 2003, with $55 billion flowing into commodity investments in Q1 of this year. Calpers alone is listed as increasing its commodity exposure from $500 million to $7 billion. Yet, isn't this to be expected? Good managers should be expected to deploy capital to the areas they feel will see that greatest potential. While the risk are present, fund managers are under increasing pressure to generate abnormal returns. Right now, commodities and energy plays represent some of the best opportunities, but the party may be coming to an end as Congress and regulators are considering limiting fund investment in commodities, along with placing larger margin requirements on speculators. Yet to be seen is whether the higher margin cost, or increase cost of carry will force index funds and speculators to open up stored reserves - speculated in some cases to be in cargo ships off the coasts of various countries. Nonetheless, it will change the dynamic. Whether it changes to price trend is yet to be determined.
Like Barron's, a short-term correction would not surprise me. Nor would a retest to the $100-110 range. Breaking $100 would probably signal or long-term correction, and a possible bursting of the bubble, but even Barron's is not projecting the prices to fall this low. In fact, it has actually done a pretty good job of outlining both the bull and bear arguments, while also tempering how much it expects the prices to fall even if the correction it is predicting is severe enough to be bubble bursting. In the end, Barron's itself may have placed the best crude oil hedge yet.